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Fixed income

A year of change

Mark Nash, head of fixed income, weighs a new volatile environment for investors.

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2018 has heralded a period of change for financial markets.

US interest rates are higher, China’s economy has slowed significantly and volatility has returned.

After a decade of easy money flooding the financial system and buoying risky assets, the question investors should now be asking as the liquidity taps are turned off is how to navigate this new world?

The US Federal Reserve (Fed) for a start has been much more aggressive in raising interest rates this year than many in the market, including us, would have expected.

At the same time economies in the rest of the world have slowed, no doubt exacerbated by the US government’s aggressive trade tariff policies. Emerging markets have felt the full brunt of this dynamic as the US dollar strengthened and investors looked for the exit.

Equities and bonds across the developing world have been hit by a significant risk off period which by mid-year had started to feel much worse than the ”taper tantrum” selloff in 2013 and the market wobble in 2016 when China devalued the yuan. In both those cases, however, the Fed backed off and markets calmed down.

But this year it’s different.

The Fed has had no choice but to carry on raising rates despite the pain being inflicted on the rest of the world. America’s output gap has closed, unemployment is low, and there is no spare capacity in the system. The Fed’s new Chairman Jerome Powell signalled as much in May when he said that any fallout from US monetary policy would be “manageable” for emerging markets.

The wave of selling across the developing world would suggest anything but.

And then there is China.

The world’s second-largest economy has slowed in 2018, so much so that cyclically and structurally the country is in a much weaker position. This is at a time when US interest rates are rising, the dollar is strengthening against the renminbi and China has been slapped with aggressive US trade tariffs.

For years China, a net exporter of goods, has pledged to keep its exchange rate stable to help prevent deflation from spreading through the rest of the world. If policymakers were to stem the recent bout of currency weakness (and not burn through their reserves) they would need to raise interest rates and they can’t.The Chinese government’s main goal is to improve living standards for its 1.4 billion people so rates need to stay low to support domestic spending and employment growth. This means that policymakers will have to let the renminbi continue to slide, further risking global growth.

It also raises the spectre of more volatility, which finally returned to financial markets in the first half of 2018. The wild price swings evident in risky markets could also spread to US assets if the renminbi was to significantly break out against the US dollar. At the time of writing, it had not yet.

In this more normalised environment where the market is increasingly fluid and volatile, absolute returns funds will come to the fore in my view. Managers who have the ability to invest anywhere and go long or short will be best placed to take advantage of investment opportunities in the new world.

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